How to Lose a Lawsuit

Man vs. MetWest In October 2015, one Thomas Kennis sued MetWest in the U.S. District Court of Central California for the company's oversight of Metropolitan West Total Return Bond MWTIX. Kennis' lawyers alleged that MetWest's rent was too damn high. "Defendant breached [its] fiduciary duty by receiving investment advisory fees from the Fund that are so disproportionately large that they bear no reasonable relationship to the value of the services provided by the Defendant."

The plaintiff's complaint: When MetWest Asset Management worked for other mutual fund companies as a subadvisor, it earned a maximum of 20 basis points per year. (One contract ran as low as 5 basis points, at the final breakpoint.) But when running money for its own organization, with MetWest Total Return Bond, it was paid 35 basis points, even though MetWest Total Return Bond was by far its largest account. Forget volume discounts; this was a volume premium.

It seems from the initial evidence that a case could be made.

Advisors vs. Subadvisors MetWest's counter was that serving as the fund's advisor, as it does with MetWest Total Return Bond, is fundamentally different from being a subadvisor. Fundamentally different tasks deserve fundamentally different prices; therefore, the apparent discrepancy in fees does not exist. Apples have been compared to oranges.

The problem with this claim is that the additional services required from advisors are minor, such as determining the fund’s net asset value, filing documents with the SEC, communicating with the board of directors, and so forth. MetWest Total Return Bond is huge--$78 billion. One basis point of the fund’s assets is $7.8 million, which seems more than enough to cover those activities. Which leads one to wonder--what about all those other basis points?

(The fund does incur various other operating expenses, such as paying its transfer agent, answering shareholder questions, and hiring a custodian. Several of its share classes also levy a 12b-1 fee. However, as these costs are not borne by the advisor--and are collected from shareholders as additional charges--they are irrelevant to this discussion.)

Back in the day, Jack Bogle heard similar claims and would have none of it. In the mutual fund fee lawsuit of Jones v. Harris, ultimately settled by the U.S. Supreme Court in 2010, Bogle filed a brief on behalf of the plaintiffs. He wrote:

No credible study has ever been able to isolate the assertedly large extra costs, somehow hidden in fund advisory fees and disclosure prospectuses, that are said to make managing dollars in mutual fund portfolios so much more expensive than managing dollars in other institutional (e.g., pension, college endowment, etc.) portfolios.

In any event, the extremely low overall costs of many index funds offered by Vanguard and other firms, which essentially provide all mutual fund services to their shareholders except investment advice, establishes that the extra costs of serving retail customers could not possibly account for the much larger fees those customers pay.

More Is Less? MetWest also argued that running a giant fund is trickier than running a small one. The claim impressed Judge Wu, who wrote, "Investing in bonds for a large mutual fund like the Fund is harder than investing in bonds for a small fund. MetWest cannot simply buy the same securities in the same amounts as the Fund's AUM increases. The adviser has to search the markets for securities that fit the investment strategy."

Those sentences are correct. The marginal cost of investing new assets is not zero. On the other hand, the real question is whether the marginal cost of investing those assets outweighs the marginal revenues. That is, if a fund becomes $10 billion larger, so that its management fee of 0.35% generates $35 million more in revenue, will its costs of portfolio management also rise by $35 million?

Fat chance. It's nowhere near that hard to find additional securities.

Granted, a successful fund might need to spend a pretty penny on its existing employees to keep them from jumping ship. That, in fact, is what occurred at MetWest. At times, “compensation for certain of the Fund’s portfolio managers as well as fees MetWest paid to intermediaries” squeezed the fund’s profit margins (if not necessarily its profits.)

That is necessary and understandable. Successful businesses share their rewards with their employees. They also need to pay outsiders who sell their company’s wares. But neither of those items support the judge’s initial point, which discussed the effort required to run a portfolio that holds many securities.

Legally Bound In short, I am unconvinced. But there is investment logic and then there is legal logic, and the two do not necessarily agree. In Jones v. Harris, the Supreme Court cared not for Bogle's expert analysis and ruled for the defendant. Nine years later, Wu reasoned similarly. He dismissed the suit, calling the plaintiff's comparisons "inapt." Unsurprisingly, he cited the Jones v. Harris decision when doing so.

Kennis promptly appealed the decision. Good luck with that. The courts have amply demonstrated that they do not believe that advisory services closely resemble subadvisory agreements. They also do not wish to address potential conflicts of interest that occur when a fund’s distributor and advisor work for the same company. If the plaintiffs are not permitted those arguments, I cannot see how they can win in a court of law.

Indeed, they never have. Not once has a mutual fund company been found guilty of overcharging its shareholders. No board members have been sanctioned. In practice, although not in theory, investors bear the sole responsibility for ensuring that their funds levy appropriate fees.

That’s fine with me. Twenty-five years ago, I wrangled with Bogle about Franklin U.S. Government’s FKUSX management fee, which had remained steady even as the fund grew 100-fold. He considered that a travesty, while I maintained that the marketplace would settle the matter. What neither of us disputed, however, was that Franklin had profited handsomely from its fund’s success.

Speaking of buyer beware, today's installment of Ignites (a paywalled publication, thus no story link is available) carries this disclosure from Morgan Stanley:

“Although we seek to charge all fund families the same revenue-sharing fee rate schedule, in aggregate, Morgan Stanley receives significantly more revenue-sharing from the families with the largest client fund share holdings at our firm. This fact presents a conflict of interest for Morgan Stanley to promote and recommend funds from those fund families rather than funds from families that, in aggregate pay less revenue-sharing. In addition, since our revenue-sharing rates are higher for funds with higher management fees, this fact presents a conflict of interest for us to promote and recommend funds that have higher management fees.”

You can’t say that you didn’t know.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.